The creation of payment channels and how they work

Published April 7, 2022

The year 2021 was a transformative time for payment channels. While they had already become more important due to the rise in ecommerce, the pandemic accelerated its development with millions of people embracing online shopping. The ways in which people engaged with businesses expanded and so did the range of payment channels they were wanting to use. As we move into a more digitally driven future, they will be critical to the way businesses operate, so what are they, how do they work and how can you choose the right option for your business?

Payment channels are simply the way in which merchants accept payments and get them verified by banks or other payment providers. These could include anything from credit and debit online card payments, automated clearing houses or any one of the growing number of payment methods businesses are willing to take on.

Why were payment channels created?

Throughout history, the main aims have been the same — to make sure payment happens as quickly, safely and efficiently in a way in which both parties can have confidence that everything is above board. The only real difference is the dramatic changes in the technology which makes all this happen.

The first payment channels would have involved the simple barter of goods and services between people. This was replaced by cash which in turn would be replaced by the modern options we have today.

It was in 1846 in which the first ever credit card — called Charge-it — was created by an American banker. The direct debit system came into being in 1964 which allowed people to schedule regular payments from their bank every month, while debit cards became common from the late eighties onwards.

From hand-to-hand payments in the days of cash, to card payments, online transactions and the modern iteration in which payment channels facilitate the movement of cryptocurrencies from one user to another, businesses have been seeking new ways to get money from buyer to seller as quickly as possible.

However, it was the internet which truly changed the game. From the mid-nineties onwards, companies began to experiment with ways in which they could take money online. Pizza Hut lays claim to making the world’s first online transaction in 1994 when it allowed someone to buy a pizza from its website.

The rise of another technology — the smartphone — created yet another option in the form of mobile payments. In 1997, Coca Cola introduced a way for their customers to make payments by sending a text message from a mobile phone. Today these have become common with options such as Apple Pay, making it easy to link cards to your mobile phone and make contactless payments.

Today, the latest innovation is in the realm of cryptocurrencies. These allow for the secure and trusted transfer of digital currencies from one wallet to another, where they can then often be transferred into fiat currency.

Payment channels in the modern world come in all shapes and sizes. Today, people will expect to choose from a growing array of options including credit/debit card payments, bank transfers, ACH transfers, mobile payments, contactless payments, online payments and in some cases cryptocurrencies.

They react to a changing world in which technology is transforming customer expectations. People are keen to have their choice of payment channels to ensure they can move money from one place to another in any way they live. Businesses are having to evolve quickly to meet these new demands.

How payment channels work

Payment channels work in slightly different ways depending on the method of payment, but they all follow a basic process of authorization, settlement and funding. For credit or debit card transactions, for example, the customer uses his card at a terminal — either tapping, entering a pin or swiping. That generates a payment request which is sent to the card issuer which checks if that person has enough funds in their bank. Authorization is sent back at which point the merchant approves the transaction.

The rise of cryptocurrencies such as Bitcoin and Ether has seen this space move on even further. The blockchain offers a new way to move money and information from one place to another and it needs a new form of transaction. In cryptocurrencies the transaction is managed in a distributed trustless way.

Rather than taking a payment and asking one entity — the bank — if the customer has enough funds, the vendor will be asking all the nodes which validate the blockchain network. They would then create two blocks which would facilitate the transaction. This is more secure because in order to create a fraudulent transaction criminals would have to compromise all nodes governing the block.

Things to consider when choosing cryptocurrencies

Today, then, people can choose from a huge range of different payment channels including debit and credit cards, mobile pay, contactless, email, online banking, cryptocurrencies and many more. They each have their different strengths and weaknesses, and customers may choose between different payment channels depending on their own personal tastes and their own requirements. For example, people who pay via cryptocurrencies enjoy the speed, privacy and affordability of making instant payments. This can be useful when making transactions overseas as it can avoid the need for exchange fees.

Mobile phone payments are more convenient and enable people to bundle everything into the one easily usable device. Contactless payments have become more popular due to the enthusiasm for convenience and the need to reduce opportunities for transmission of disease.

As a business, you need to ensure you can continue to cater to the needs of your customers. As technologies evolve and the number of available payment channels grow, they are choosing to spread their activity across multiple channels. It is not a case of people choosing one option over the other — they are likely to add to the number of payment channels they use.

Businesses need to cover every base — from those who prefer traditional options such as cash to those choosing more modern options such as mobile payments and cryptocurrencies.

Each of these will come with their own advantages and disadvantages. Credit and debit cards are fast and convenient, but they can come with processing fees which you as a business might have to absorb.

ACH payments are fast, secure and relatively low cost, when compared with credit cards, but they are not instant relying as they do on three batches during each working day. They are also restricted to the US.

Mobile phone payments are fast, easy and secure, but they can come with a cost and are tied to particular phones.

Accepting cryptocurrencies enables you to expand by offering transactions in bitcoin and other major tokens. This can put you ahead of the curve and make you more attractive to some customers. However, cryptocurrencies can be highly volatile. Despite Bitcoin becoming more correlated with the wider financial sector in recent times, it can still be difficult to work with.

The growing number of payment channels certainly makes life a whole lot more complicated for the humble business which is just trying to make it easier to engage with their customers. However, the benefits of accepting multiple payment channels outweigh the challenges. As long as you ensure each channel is secure and managed by reputable providers the more options you give your customers to pay, the fewer interruptions you’ll experience in the service.

A better bottom line.

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